What Investors Need to Know to Make the Right Play in Oil

By Tom Clancy After hearing a commentator on TV recommend investors buy Transocean (RIG) and Diamond Offshore Drilling (DO) as a “derivative oil trade," I felt compelled to share some insight that investors and traders alike should consider before taking such positions. Understanding the difference in business models and industry dynamics is critical to making the correct oil play.

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Making money from an oil & gas well requires a disciplined management team, because ultimately the money is made when management invests only in projects that provide an appropriate return on invested capital. Those investors that watched the natural gas heavy Exploration & Production (E&P) companies make new lows this summer saw the result of undisciplined management. The natural gas markets were oversupplied, but in order to achieve the production growth targets that management gave to Wall Street, they could not resist adding another rig at every uptick in natural gas prices, which then pressured the price below their cost of capital. Producing below your cost is an unsustainable activity, and is especially high-risk in an industry where the capital structure is heavily weighted toward debt (which also makes profits higher when prices are increasing).

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When you start investigating companies that make money from oil & gas production but do not directly own the wells, you need to understand the industry dynamics. To be sure, these are constantly changing, but to understand what is happening in the current environment, one must watch the rig count and the activities of the Export-Import Bank (or EIB). The EIB provides low-cost funds for international buyers of US exports. Since it costs $300 mm or more to build a deepwater rig, one rig can offset a lot of toys or cell phones made in Asia. As I pointed out in my last post entitled Ben Bernanke's Fatal Flaw and Our Modern-Day Currency War, if the major economies are trying to balance trade rather than freely float currencies, buying US-made airplanes and deepwater oil rigs can go a long way to correcting an imbalance. In addition, the buyer gets a cash-generating asset equipped with the latest technology. The traditional industry cycle is that prices rise, causing drilling activity to increase, which increases asset utilization and day rates, and can spur a new equipment cycle if the cycle lasts long enough.

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The financial incentive caused by low-cost EIB funds has caused the manufacturing cycle to remain strong, despite a decline in drilling activity. To complicate matters, these rigs are increasingly owned by companies that are not traditional rig operators, like DryShips (DRYS)(which recently sold 20% of its rig division). This is changing the industry dynamics; it has received delivery of about 60 rigs in 2010 despite having utilization rates between 70% and 80% on its existing fleet. To complicate matters, the moratorium in the Gulf of Mexico is causing rig operators to move rigs from the Gulf to other regions where the assets can be put to work. For comparison, in first quarter of 2007, there were 99 rigs operating in the Gulf of Mexico; the rig report I received from Tudor, Pickering, Holt this week counted 35 rigs in the Gulf. The rig-building cycle still has some legs and, as we have seen, the order flows of rig equipment manufacturers like National-Oilwell Varco (NOV) and FMC Technologies (FTI) remain strong. However, each new rig increases the fleet, which pressures the day rates charged by the traditional rig operators like Transocean and Diamond Offshore. In fact, these traditional operators now have a comparatively older fleet (though Transocean has been acquiring new rigs, too) and, in my opinion, will be among the last in the cycle to see an uptick in profits. Also, these “non-traditional” operators, with brand-new, state-of-the-art assets, will rely more heavily on the “Service” companies to handle the outsourced operation of the rigs, which bodes well for companies like Schlumberger (SLB) and Halliburton (HAL). This summary is an oversimplification, as the age of the rig is not the only input in the decision-making process. But new rigs plus the rigs previously operating in the Gulf of Mexico illustrate my point about increasing rig counts and a different competitive landscape.

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